Financial Accounting

Financial Accounting

Professor Gromis and Venuti

Università degli Studi di Torino

Business and Management - 2nd year

Contents

• Lecture Topics
• Lecture Refresh and Introduction - page 2
• Lecture Financial Information and Schemes - page 5
• Lecture Accounting Principles, Contents and Policies - page 10
• Lecture Adjusting Entries - page 12
• Lecture Fixed Assets, Depreciation and Intangible Assets - page 13
• Lecture Inventory and Receivables - page 17
• Lecture Owner’s Equity - page 20
• Lecture Liabilities and Provisions - page 23
• Lecture Financial Statement Analysis - page 25
• Lecture Financial Statement Analysis Pt.2 - page 29

Lecture 1 – Refresh and Introduction

Professor Gromis, Chapter 1 of the book

What is accounting?

It is the art of organizing, maintaining, recording and analysing financial activities. Can also be defined as the process of designing and operating an information system for collecting, measuring and recording enterprise’s transactions and summarizing and communicating the results to users to facilitate making financial/economic decisions.

Language of business

It translates the accounting information into meaningful terms that are used by the parties involved.

Who uses this information?

• Managers: to make appropriate decisions
• Investors: to evaluate the financial status and future prospects (as the firm’s capability to pay dividends)
• Bankers: to extend credit
• Employees and Customers: to be informed about the condition of the organization
• Suppliers: to decide whether to sell goods to that entity or not
• Government: to assess taxation and provide a basis for national statistics

What does the accountant keep?

The accountant keeps track of all business transactions. Business transactions are the economic events that affect the financial condition of the business (it is every event which involves money and involves at least two movements).

Financial Statements are public! But if you are not listed in the stock exchange you are not obliged to publish it on the website (they are published but to find them you need a database or other tools).

Economic View: (Income Statement) → Performance

• Costs for purchase, so input
• Revenues for sales, so output

Financial View: (Balance Sheet) → Financial Position

• Pay money for purchase
• Receive money for sales

In the Financial View, the two parts can be divided themselves into two: past and future.

Flow Types of Account

• + Cash
• - Cash
• + Bank
• - Bank

Financial Account

• + Account receivable
• - Account receivable
• - Account payable
• + Account payable
• + Cost
• + Revenues

Economic Account

• - Revenue
• - Cost

Capital Account

• - Equity
• + Equity

How to record a business transaction

Almost every company in the world uses a system of recording known as “double entry bookkeeping”. This name derives from the fact that each individual transaction is entered at least twice. Moreover, each business transaction is entered in at least two separate accounts, which are in a simultaneous and opposite way. That means the sum of the amounts entered on the left-hand side is equal to the sum of the amounts on the right-hand side.

The Ledger book

All the T accounts generated in the course of business must be collected in a book also known as Ledger Book. Information by business transactions is collected in a systematic way: every account describes what has happened in a specific business item. If you want to calculate the balance of an account you must sum all the amounts on the left side, sum all the amounts on the right side, and finally make the difference between these two totals.

The Journal book

“Journalizing” is the process by which transactions are posted in the “journal book”. In the journal book, it is possible to find a summary of all the transactions that have occurred on a day-to-day basis.

Chart accounts

It is the list of all the accounts that a company can use to record transactions. In Italy, like in many other countries in Europe, each company uses its own developed charter of accounting. Our codes, in this course, are:

• Not current assets
• Current assets
• Equity
• Liabilities
• Revenues
• Costs

When to account

Business transactions shall be recorded when the company issues or receives a justifying document, some examples are:

• Bills (utilities)
• Receipts
• Invoices
• Check/Cheques
• Bank statement
• Customers declarations
• Income tax returns

The functions of financial accounting

• The recording and control of business transactions
• To maintain the accuracy in recording
• To meet the requirements of the law
• To present final financial statements to the owners of the business
• To present other financial reports and analyses
• To facilitate the efficient allocation of resources and supporting the economic decision-making process

The objective of financial statements

The objective of financial statements is to provide information about the financial performance and changes in financial position, of an entity that is useful to a wide range of users for making economic decisions. i.e. Should I invest in this company? Should I vote to keep the current management or replace them? Should I lend to this company? Should I sell to this company on credit?

Moreover, the objective of the financial statements is also to be the scorecard of the past; this is called the “stewardship objective”, it focuses on both past performance and how the entity is likely to perform in the future. The stewardship objective is about assessing management’s competence and integrity including the success of their strategy in managing the business.

Limitations of financial statements

One of the major limitations of financial statements is that it does not take into account the non-monetary facts of the business like the competition in the market, social and environmental matters.

Corporate and Social Responsibility

In the last decades, corporate objectives have shifted from emphasis on profit to the benefit for other kinds of users in the annual report. As a result, listed companies include a corporate social responsibility report in their annual report. Corporate social responsibility describes policies adopted by the entity to benefit the local community in which it operates, its employees, customers, and the environment and in general how the company conducts business in an ethical manner.

Lecture 2 - Financial Information and Schemes

Professor Venuti, Chapter 2 of the book

General Purpose Financial Statement

Why do we need a financial statement? To collect information, (in this case quantitative information → accounting information). Accounting information consists of Operating Information, Financial, Management and Tax Accounting. Operating information is useful for the CEO (more precisely managers); managers are appointed by the owners (or stockholders) who need statements periodically to check how the company is doing. These reports are prepared by the managers (and consist in the Financial Accounting).

All the reports (Statements) can be classified into one of two categories:

• Stock or Status: As of a specified instant in time, like snapshots; is an accumulation of flows (i.e. balance sheets).
• Flow: Cover a specified period of time, like a motion picture; is a change in stocks (i.e. income statement or cash flow statement).

There is just one figure that we will find twice in the statement which is Net Income (both in the balance sheet and Income Statement).

General Purpose Financial Statements are the statements not prepared for a specific purpose (acquisition, merger or company transformation). Are intended to meet the needs of users who are not in a position to require an entity to prepare reports tailored to their particular information needs. Information included in this document are:

• Asset
• Liabilities
• Equity
• Income
• Expense

Assets

Resources controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity (Stock Variable).

Liabilities

Present obligations of an entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits (Stock Variable).

Equity

The residual interest in the assets of the entity after deducting all its liabilities: E= A-L or A=E+L (Stock Variable).

Income

Increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants (Flow Variable).

Expense

Decrease in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants (Flow Variable).

Financial Statements

Financial statements are prepared at least once a year, but also quarterly or monthly for instance. The 12-month period is called “the reporting period”. It contains primarily historical information. The reporting entity can prepare separate financial statements or consolidated financial statements if part of a group. The presentation of financial statements depends largely on the different standards used by the entities.

The Annual Report

The Management Letter: management discussion on developments during the year and current state of the company.

Balance Sheets

Assets, liabilities & owners ‘equity as of a specific date; also called statement of financial position. It is the prime source of information.

Income Statement

Is an accounting statement that reflects the operating results on an entity for a particular accounting period.

Statement of Retained Earnings/Changes in Equity

Cumulative sum of undistributed profits and changes in equity’s owner’s equity between two balance sheet dates.

Statement of Cash Flow

Operating, Investing and Financing activities cash flows for a specific period of time. Basically provides information about a company’s cash receipts and cash payments.

Notes

Significant accounting policies, estimates; descriptions and explanations of all the previous documents.

The Auditors’ Report

The owner cannot totally trust the manager, so this is the report prepared by an external professional nominated by the assembly (big 4 auditors company: EY, KPMG, DELOITTE, PWC).

Balance Sheet

It is the prime source of information about an entity’s financial position as it summarises the elements directly related to the measurement of the financial position: an entity’s assets, liabilities and equity.

Balance Sheet Structure

• Non-Current Assets
• Current Assets
• Equity
• Non-Current Liabilities
• Current Liabilities

Assets

• Long Term Assets
• Tangibles (land & buildings)
• Intangibles (rights and patents)
• Financial (participation in other companies)
• Current Assets
• Cash
• Receivables
• Inventories
• Temporary Investments
• Pre-paid expenses

Equity

• Share Capital (nominal value of the stocks)
• Retained Earnings
• Additional Paid-in (eventually, if you sell stocks at a price higher than nominal value)
• Net Income (profit or loss)

Liabilities

• Long Term Liabilities
• Loans (if you have to pay in more than 1 year)
• Bonds
• Provisions for employees’ benefits
• Current Liabilities
• Loans (1st year)
• Trade payables
• Provisions for risks and charges

*The difference between current and long-term asset is that the first provides benefits just for 12 months. In fact, an entity shall classify an asset as current when:

• It expects to realize the asset or intend to sell or consume it in its normal operating cycle;
• It holds the asset primarily for the purpose of trading;
• It expects to realize the asset within 12 months after the reporting period;
• The asset is cash or a cash equivalent.

Income Statement

Income Statement

Revenues

• Operating cost

Operating Profit

• Financial cost

Financial revenues

Pre-tax Profit

• Taxes

Net Income

An income statement is an accounting statement that reflects the operating results of an entity for a particular accounting period. Minimum information on the face of the Statement of Comprehensive Income includes the following:

• Revenue
• Finance cost
• Share or profit or losses of associates and joint ventures
• Tax expense
• Discontinued operations
• Profit or loss
• Each component of other comprehensive income
• Total comprehensive income
• Profit or loss attributable to non-controlling interests
• Profit or loss attributable to owners of the parent
• Comprehensive income attributable to non-controlling interests as well as to owners of the parent.

N.B. this is an example of how to complete an Income Statement; there are several ways to do it, also with revenue minus all the costs in just one step.

Statement of Cash Flow

It is for financial analysis, it tries to explain how the company produces cash, if you have produced cash using your operating activity, using investments or using financing activities. It is very important to verify if the cash flow generated from the operating activity is positive (so you are a healthy company) otherwise you have to investigate which activity lets you earn cash.

Basically, the statement of cash flow explains how the amount of cash on the balance sheet at the beginning of the period became the amount of cash reported at the end of the period. It reports cash inflows and outflows in three broad categories:

• Operating activities
• Investing activities
• Financing activities

Notes

Notes are an integral part of the financial statements, containing additional information with respect to those presented in the statement of financial position, income statement, cash flows statement and statement of changes in owners’ equity. Notes provide narrative descriptions or disaggregation of items presented in those statements and information about items that do not qualify for presentation in those statements.

IAS & IFRS

International Accounting Standard (old name) now is called International Financial Reporting Standard: they are international rules, adopted by a committee. We are trying to adopt these rules all over the world in order to have the same accounting system worldwide. Europe was one of the first to make these rules mandatory for a large number of firms. In cases in which local rules are applied, not only changes the structure of a statement but also the method of evaluation, so it is very difficult to match and compare different companies from different countries.

IAS 39 was about the evaluation of financial instruments, nowadays it has been discovered that principle was not perfectly adaptable to the current situation: so, it was deeply changed and at the moment they are publishing (soon, not yet) the IFRS 9.

IAS 1 according to it, a complete set of financial statements comprises many documents:

• A statement of financial position as at the end of the period
• An income statement for the period
• A statement of changes in equity for the period
• A statement of cash flows for the period
• Notes, comprising a summary of significant accounting policies and other explanatory information.

Lecture 3 – Accounting Principles, Concepts and Policies

Professor Gromis, Chapter 3 of the book

In the preparation of its financial documents, an entity should provide a true and fair view about its financial conditions and operating results. Anyway, the concept of true and fair view does not mean absolute truth about enterprises. For instance, if I am a family business I will try to reduce my profit in order to pay less taxes; while if I am a manager in a big company I will try to make happen better performances in order to raise my wage. As the concept of true and fair view, there are many other principles and concepts to assist in the development and review of accounting standards and to assist auditors in forming an opinion on whether financial statements conform with accounting standards.

The Nature of Accounting Principles (First Part)

Two accounting concepts play ‘a pervasive role’ in financial statements:

• Going Concern: when a company is able to survive for one year; the value of an operating company is superior to the value of its assets. If I buy an operating company I am buying a company whose value is superior to the sum of its items all together. Is the assumption that an entity will remain in business for the foreseeable future; by making this assumption, the accountant is justified in deferring the recognition of certain expenses. If there is reason to believe that the entity will not be able to continue in business, the asset should be valued on a cessation basis.